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If China was a company?

Published: August 1, 2013 by Ricco Friedrich

“It is not just the places that you visit, but the experiences you have and what you learn from the people that you meet along the way that make a Journey Magical”, Anon

The evolutionary journey China is on is not the miracle repeatedly referred to. Rather, it stems from a desire and hunger to be the best. Like any magical, mystifying and messy adventure, China has had its share of trials and tribulations and, in spite of all the “China bashing”, the outcome (so far) has been staggering. The current growth in GDP is equivalent to adding an economy the size of SA each year. Last year, China added 88GW to their power grid, almost twice the total size of Eskom’s annual production. Since Deng Xiao Ping took over as the leader of the People’s Republic of China a little over 30 years ago, 600m people have been lifted from the “bear pit” of poverty.

Being my first time to China, it wasn’t hard to be seduced and fall in love. Fortunately I was not their long enough for the thrill to fade. Fortunes are being made in China that would be hard to make anywhere else in the world. And while the opportunities abound, the challenges are immense. Legendry UK Fund Manager Michal Bolton[1] learnt the hard way after failing to crack China, admitting it had proved more difficult than he anticipated.

Each day we endeavour to select great companies in which to invest. While there is no blue print for success, there certainly are some key characteristics that differentiate strong companies from weak ones. Over time, we have found that you should never compromise on these. Applying these same principles to China reveals some interesting comparisons, lessons and insights that may elevate our great nation’s chances of success.

 

Management

Strategy/implementation – “the five year plan”

China is at the early stages of implementing its 12th five-year plan. These plans are a series of social and economic initiatives to set growth targets and launch reforms. Great businesses must not only have a well thought out plan but need to be able to execute and continuously adapt to changing circumstances. Like any great business, the government will first test these reform measures on a small scale before fine tuning and rolling out on a national basis. A great example is the recent experiment with residential property taxes in Shanghai and Chongqing. Not only does it create a sustainable source of revenue for local governments but is also increases the holding cost for investors in the potentially overheated property market.

Recognise weaknesses and adapt

Great management teams are also able to recognise weaknesses in their business and adapt accordingly. Many companies have suffered mainly due to management’s inability to acknowledge that there is a problem, which means there is never a solution. While imperfections exist in the socialist market economy that is China, policymakers are not afraid of structural change on hotly debated topics such as elevated debt, growing environmental concerns and unfavourable demographic changes.

Attract and retain talent

This year China will produce 7.3m graduates. China has increased the number of graduates per 1000 entrants to 22.5 from 20 years ago. In contrast, SA currently has 10 graduates per 1000 entrants.

China College New students

Having such a large resource pool to draw on is an enormous competitive advantage for China. With a higher level of skills, it means more people are able to enter the work force, reducing the much needed dependence on fixed asset investment (which still makes up 46% of total GDP). The latest five-year plan aims to increase the contribution to GDP from the services sector to just under 50%, eventually exceeding 60% by 2030.This change in mix will have a dramatic impact on per capita GDP (i.e. the per capita contribution to GDP in the services sector is higher than traditional manufacturing.

Governance

This is the one area that would be a major concern to any investor in China. On our trip, we met with an expat from the US who has been doing business in China for the past six years. Before building up his successful business in trading air tickets, he experienced firsthand the impact of poor governance. Dealing with the insidious government and State Owned Enterprises is challenging, especially when up against the mantra “the government is always right”.

 

Balance Sheet Quality

A good company should always have a strong balance sheet and very seldom would it require debt to grow. On this score, China has of late not been the model business. While very high savings levels (32% in China vs almost zero in SA) support investment, the recent run up of total debt to GDP is of major concern. Using Total Social Funding (TSF)[2], China’s debt-to-earnings ratio (i.e. GDP) now stands at over 200%. In the first quarter of 2013 alone, TSF has grown by 63%, with non-banking credit up 127%. This rapid growth in debt in the so-called “shadow banking sector” was spurred by China’s rapid increase in the required Reserve Ratios and restrictions imposed on bank lending post the 2008/2009 stimulus measures.

Total Social financing

Earlier this year the Chinese government imposed restrictions on lending to those industries that are suffering from overcapacity (such as steel, cement, ship building, property developers, exporters and packaging). In times of need, these companies were forced to look elsewhere for funding and approached trust companies (the biggest part of the shadow banking system). Unlike SA, the consumer in China is relatively unleveraged (debt to assets of only 5%). The risk lies in the corporate sector, including state owned enterprises. Fitch, which recently downgraded China’s credit rating, is worried about the entire corporate portfolio, recently made worse by the struggling European economy.

Against this backdrop, who can believe the current level of non-performing loans (NPL’s) which in aggregate for the banks is less than 1%[3]. Such a rapid increase in debt is normally followed by higher NPL levels, especially when GDP growth in China has been slowing from 10% to closer to 7%. The challenge lies in the fact that the shadow banking sector has become a much bigger part of total debt and, due to poor disclosure, no one really knows what the real situation is regarding non-performing loans.

This is one of those “known unknowns” and should any problems emerge in the shadow banking sector it is unlikely that it will be contained. This explains why the Chinese banks are all trading on price-to-earnings (PE) multiples of 6x, Price to Book’s of 1.1x (with current Return on Equity of 20%) and 5 to 6% dividend yields.

 

Allocation of capital

China has overinvested in parts of the economy and this has negatively impacted on utilisation levels. For a company, low utilisation levels generally imply low margins due to the underrecovery of fixed overheads. Utilisation levels generally fluctuate with economic activity but may also be an indication of overinvestment by a company in relation to demand expectations. With overcapacity comes significant price competition, which further drives down returns for shareholders. Sometimes this may create a good buying opportunity.

The Chinese economy is suffering from overcapacity in many industries. Estimates are that utilisation levels may be as low as 60% due to overinvestment following excessive stimulus measures in 2008/2009. This can be seen in the cement industry where prices of cement declined by over 20% last year and profits halved. The same can be said for the steel industry. While conditions in the short term may improve slightly from very depressed levels, steel and cement intensity (per capita) will likely decline from current levels over time.

the photo below is an example of overcapacity in the residential sector – enormous blocks of vacant apartments on the outskirts of Beijing

CognitioQ22013.-007

One of the most important drivers of the shareholder value creation over time is the return management generates on the capital they retain in the business. For a country, this ratio is referred as the Incremental Capital Output Ratio (ICOR). This measures the impact of a unit change in capital stock on the growth in output (GDP). In China’s case, this ratio has been increasing rapidly from around 3x in 2007 to over 6x in 2012. In other words, it takes twice as much capital to generate the same amount of GDP today than it did six years ago. This is not a good sign, irrespective of the side of the fence you may be sitting on. Either debt needs to increase further (i.e. the growth in capital stock is partly funded by debt) to support the current levels of GDP growth or we will likely see a further slowing down in growth. I am in the latter camp, believing GDP growth will likely continue to slow over the remaining part of this decade to 5%. Even with the ICOR declining back to 3x, the total debt to GDP will only stabilise at GDP growth rates of 5%.

Nominal GDP

 

Innovate or die

“Investment, innovation and institutional capacity are the key requirements for growth”

Companies that fail to innovate eventually die. A great example of a company in SA that has continued to innovate and grow is Capitec. It started out in the short-term loan shark business, charging exorbitant money lending rates. Today it is taking on the big banks in attracting and growing its recurring transaction business. If the company had not changed its strategy, it would probably not exist today.

Similarly, China would not have achieved its coveted success if it were not constantly experimenting with economic reform. With a focus on improving free market price discovery, the twelfth five-year plan is a big step change in direction. As in the past, they will test the idea on a small scale first, that way substantially increasing the chances of success when a new idea is rolled out nationally.

They say necessity is the mother of all invention. This was certainly the case when SA was isolated from the rest of the world. However, in a recent article “Innovation the only way out of the mire”[4], Accenture says SA suffers from an “innovation death spiral”. Without wanting to be too pessimistic, SA’s competitive position[5] has deteriorated over the last 10 years from 25th to 52nd (out of 144 countries). The indicators in which SA scores the worst in order are 1) inadequately educated workforce; 2) restrictive labour regulations and 3) inefficient government bureaucracy.  SA will not supply the rest of the world with manufactured goods and mining is fast becoming a much smaller part of our overall GDP. To ensure that we don’t become irrelevant, we need to focus on our strengths in the areas of financial market development (3rd) and good scientific research institutions (34th) and build on our weaknesses above (through effective and accountable reform).

 

Epilogue

“A survey of all states in the world, will show that those states that undertook reforms became strong while those states that clung to the past perished.”

These were the words written by Kang Youwei after China lost the Korean War to Japan in 1898. These words are as relevant to our daily task of identifying good businesses to invest in as well as improving our lot as a country.

China will continue on its journey at lightning speed (see pictures below in Appendix). There will be enormous opportunities for investors – but caution will be required. Do not go into China thinking you will strike it rich fast. Warren Buffet’s investment in BYD is a reminder of the challenges of investing in China. Since Berkshire’s purchase in September 2008, operating profits and margins have more than halved.

Xie Xie!

Shenzhen – 1980

CognitioQ22013.-011

 

Shenzhen – today

CognitioQ22013.-012

 


[1] He ran the UK-focused Fidelity Special Situations Fund which enjoyed a compound annual return of 19.5% during his 28 years at the helm

[2] TSF measures the total amount of debt in the economy and is not limited to bank loans only. It includes bank loans (both Rmb and foreign currency loans), trust and entrust loans, bank acceptance bills, corporate bond financing,non-financial enterprise equity financing, and other funding sources (e.g., insurance, micro lending, industry funds).

[3] NPL measures what percentage of the total lending book of a bank is in arrears. In this case, of every R100 lent out only R1 is more than 3 months in arrears. In Brazil for example, the NPL as a percentage of the total loan portfolio is around 4.5%.

[4] Business Day, June 21 2013

[5] Global Competitiveness Report, World Economic Forum, 2013